Reining in the Bankers

Laurence Kotlikoff of Boston University is among the economics profession’s most creative thinkers. He was a key figure in developing “generational accounting,” which offers a quantitative — and horrifying — look at the fiscal burden we are leaving to future generations. He has come up with sweeping proposals for tax reform (emphasizing consumption taxes) and healthcare reform (emphasizing universal provision of vouchers). He also developed personal financial-planning software aimed at protecting one’s living standard in a country where fiscal and healthcare policies remain a mess.

Kotlikoff’s new book Jimmy Stewart Is Dead: Ending the World’s Financial Plague with Limited Purpose Banking offers an ambitious proposal to fix — or, more precisely, replace — our ailing financial system. The title refers to It’s a Wonderful Life, in which Stewart played a trustworthy small-town banker. Any resemblance the banking industry may once have had to that movie is long gone, as Kotlikoff points out, and the recent financial sector — with bankers taking on massive risks they neither disclose nor understand, then leaving taxpayers with the bill —is better described as “It’s a Horrible Mess.”

His solution is “limited purpose banking,” which would require banks to operate the way pass-through mutual fund companies already do: as middlemen. Banks (and insurance companies) would offer vehicles for investors and depositors but would not own any financial assets, let alone gamble with federally insured deposits. They would offer various mutual funds, including ones consisting of just cash or Treasury securities for safety-minded investors. Other mutual funds would be risky, but the risks would be borne by the customers. There would be no runs on banks, because banks would no longer be in the business of borrowing short and lending long. All they would do is collect fees (and investment banks would collect fees for advising on mergers and such, but also would not own any financial assets).

Kotlikoff would set up a single government agency, which he calls the Federal Financial Authority (FFA), to replace the financial regulatory functions now housed in some 115 federal and state agencies. The FFA would require and enforce accurate disclosure of a wide range of financial transactions. It would supervise the custody of financial instruments, so a latter-day Madoff cannot claim to hold securities that he does not. The agency would hire private rating companies to assess the risks of instruments, and would not allow those rating companies to engage in any conflict-of-interest financial relationships.

This proposal is hard to categorize ideologically (something true of much of Kotlikoff’s policy work). On one hand, it takes away the explicit and implicit federal guarantees of bailing out institutions and individuals who have taken on more financial risk than they can handle. On the other hand, it gives a centralized federal agency vast power in all areas of finance. (In an example Kotlikoff gives of how the FFA would work, the agency collects details of an individual mortgage borrower’s financial situation and places this info, minus identifying details, on a public website so the mortgage can be auctioned.)

Incidentally, Kotlikoff notes, limited purpose banking would give the government a more precise tool of monetary policy. The M1 measure of the money supply would exactly equal cash plus cash mutual funds (which would be fully backed by reserves), whereas today M1 depends partly on an uncertain relation between cash and checking account balances. Presumably, the Federal Reserve would be the agency implementing monetary policy under the new system (or at least Kotlikoff never states that the FFA would take over the Fed’s monetary authority, as opposed to its bank regulatory functions).

What to make of all this? Kotlikoff has presented a thought-provoking proposal that merits attention in the debate over financial regulation. He make a cogent point that a less radical effort to separate more and less risky areas of finance (such as the Obama administration’s push for the Volcker Rule, which would ban institutions that accept insured deposits from engaging in proprietary trading) is difficult to implement in a highly interconnected financial system.

At the same time, there is reason to be skeptical of Kotlikoff’s plan. There seems little basis for confidence that the powerful federal agency Kotlikoff proposes would not succumb to the flaws and temptations that regulators have shown in recent years, such as sleeping at the switch or being overly politicized. Having so much authority in the FFA would eliminate the ability of the regulated to shop around for a lenient agency, but it would also mean the FFA’s blunders would have wide effects.

It is both a virtue and a flaw of Kotlikoff’s approach that he essentially starts with a blank sheet of paper in drawing up a new financial system. We need bold thinking to deal with the current system’s deep problems, and Kotlikoff offers that. But one wonders not just whether such a radical proposal would work if implemented, but also what it would look like after going through the legislative meat-grinder.

And of course, NO mention, not even a whisper, of the heart of the problem: forcing banks and other lenders to hand out loans at below-market rates to various high-risk, socially underperforming demographic groups. Forbidden because of racial politics to set rational terms or interest rates for appropriate to borrowers with such incomes, collateral levels, debt levels, credit histories, credit scores, and employment and law enforcement histories, lenders thus are forced to lose money on these loans when the predictably high default rates inevitably happen. Eager to unload this toxic bad debt, lenders find Fannie Mae and Freddie Mac willing to buy it, package it up with an implicit taxpayer guarantee, and sell it on Wall Street, creating an artificial market for high risk investments.

All so politicians in both parties can brag about “greenlining”, “expanding minority homeownership”, “providing a stake in the American dream to the historically under-served”, “breaking down barriers” and all the usual cliches, without a thought to the disaster they are creating. Indeed, any suggestion that that is what they are doing would be met with indignant howls that you are a “redliner”, “discriminator”, etc.

The best part is, when the house of cards falls down, the blame is put not on this layer after layer of government meddling, but on the supposed absence of ENOUGH government meddling. Government, riding to our rescue, ready to save us from the problem it created in the first place, with still more of what caused it!

And of course, NO mention, not even a whisper, of the heart of the problem: forcing banks and other lenders to hand out loans at below-market rates to various high-risk, socially underperforming demographic groups

“Forcing”? Doesn’t there have to actually be some kind of negative consequence to force someone?

I ahve never heard of any lender suffering negative consequences for not “hand(ing) out loans at below-market rates to various high-risk, socially underperforming demographic groups”.

I do know of a lot of lending agents making HUGE commissions through the early part of the 00′s selling adjustable rate mortgages and refi’s with the promise “don’t worry about that rate at the end … before then your house will have doubled in value and you’ll be able to refinance again and take money out!”

And at the other end … I’m not sure how the brilliant guys on Wall Street were suckered into buying the sliced and diced and bundled pile of crap that resulted … until we had a 47 trillion dollar credit default swap market. But I do know that we damn well need to make sure that doesn’t happen again, because we can’t handle another bailout.

Republicans are increasingly confusing capitalism and democracy. Carney is a good case in point. He gropes blindly for any way to turn the debacle we have been through into a government problem, for surely capitalism could not lead to bad outcomes, now could it?

Democracy is a political system that seeks to increase the total welfare of a people through respect for the individual: freedom of choice, movement, and expression, right to privacy and self-realization. All within the limits of the common welfare.

Capitalism is not a democratic system. It is a system that exists for a single purpose: increase material wealth for the stakeholders. It fits well with democracy through its reliance on the free market and fair competition—as far as that goes these days. This does not change the fact that it is an authoritarian system that answers directly to its owners and nobody else. As we know corporations are required by law to maximize shareholder value. The private sector is not the only one that creates wealth. Many government institutions create great wealth, the NIH laboratories and the research they do are but one example.

When sober people suggest regulation to rein in rogue elements of the private sector it is not an attack on our freedom. It is in defense of it. When it is done to regulate an industry that nearly bankrupted an entire planet, it not just our freedom that is being protected. It is our survival.

In capitalism, the only lawful way (by definition excluding force and fraud) to accumulate money is to provide others with a service or product that they want more than their own money. Thus, the more money you’ve made, the happier you’ve made your fellow man, the more service to your community you have performed, and the better you’ve made the world. Capitalism inherently promotes meritocracy, and a special form of it, rewarding peaceful service to others.

In democracy, especially in our current understanding of it (universal suffrage, one man one vote, vox populi vox dei), an 80 IQ, AIDS-infected, illiterate crackhead with 8 illegitimate children who has never had a job and lives off welfare, has a vote just as you or I do, which is to say has just as much say over public policy as you or I do. Is trusted to make sound decisions about complex long-term problems, which will require deferred gratification or understanding abstract issues of principle. That’s raving insanity.

balconesfault said he had never heard of any negative consequences of displeasing the racial preferences regime. Incredible. Like saying you knew no one who voted for Nixon, or who knew anyone who voted for Nixon.

Bankers usually quietly pay off the ACORNs and the National Action Networks, to prevent swarms of bullhorn wielding thugs descending on their place of business or even personal residences. Hordes of “civil rights” bureaucrats spread across countless agencies at all levels of government look for “racists” behind every tree and under every bed, as if a bank would deliberately deny a CREDITWORTHY minority a loan and deny itself the profits out of sheer racial animus. Not that a race-neutral, by-the-numbers method will save you; if any bank’s loans are not “diverse” enough it will be violating the Community Reinvestment Act, the Fair Housing Act, the Civil Rights Act, you name it, and opening itself up to a world of hurt at the hands of zealous and ambitious prosecutors and regulators. Protests that it is merely paying attention to the numbers will be dismissed as a mere excuse for “exclusion”, and other banks that have capitulated held up as examples.

Are you saying the bankers who created this mess performed a useful service to society? I would bet you are more or less alone to think so, even among Republicans. Frankly, they deserve a pitchfork-wielding mob outside their doors for what they did. They ruined countless Americans.

With your preference of capitalism over democracy you indirectly are proposing that fascism would be a better political system for the United States. What can I say? It worked for Nazi Germany, Mussolini’s Italy, and Franco’s Spain. So there are definitely role models.

I believe in capitalism, but history tells us that capitalism must be regulated. Otherwise there are too many ways to just take the money and run. Let me know whether you need examples. Start with the wiki on Teddy Roosevelt if you would like to study up for yourself. He had his hands full with some enterprising individuals who found ways to serve themselves before they served anyone else.

You seem to blame much on racial minorities, Carney. Are you sure you are not a racist? I’ll take your word for it either way, but read your comments, and you will see you are coming awfully close to painting yourself that way.

In capitalism, the only lawful way (by definition excluding force and fraud) to accumulate money is to provide others with a service or product that they want more than their own money.

Well, there’s being born to the right parents.

And there’s also speculative investment, as was so in vogue in the last decade. On a basic level, investment is good and critical – we need capital to be available so that people can build things and buy things and hire people and make things. But when you start getting to brokers moving around securities which are removed by 4 or 5 transactions from the original investment … I would argue that there was no more “provid(ing) others with a service or product that they want more than their own money”. There was simply out and out gambling and greed, creating profits out of nothing more than leverage, brokerage houses playing off against one another using the Fed as house money. Was it force? Nope. Was it fraud? Morally, yes … but legally, thanks to our lack of regulations, no.

if any bank’s loans are not “diverse” enough it will be violating the Community Reinvestment Act, the Fair Housing Act, the Civil Rights Act, you name it, and opening itself up to a world of hurt at the hands of zealous and ambitious prosecutors and regulators.

You should then very easily be able to point to a number of banks that underwent that “world of hurt”. Are you telling me that every institution out there had a massive liability ridden portfolio thanks to all those bad loans that overzealous bureaucrats forced them to make?

And for the life of me I have a really hard time understanding the crash of million dollar homes in California and DC and 500K condos in Florida and other high dollar market collapses around the country. Were banks really fudging the numbers to get poor black people into Los Altos Hills?

balconesfault, when the entire industry at every level is required to engage in systematic malinvestment, you don’t think that will have economic consequences?

So great is the intimidation and hysteria on this that when Sen. Phil Gramm held hearings on the Community Reinvestment Act bankers testified anonymously to shield themselves and their families from harassment.

Sure, there were other reasons for the financial collapse, with the run-up in oil prices being a prime factor.

But blaming “under-regulated” banks for doing what they were forced or incentivized to do – hand out loans to high-risk borrowers and set off an artificial bubble – ignores the real source of the financial sector’s portion of the problem, and guarantees it will be repeated.